2008 Economic & Market Outlook

Greetings to all of our St. Nicholas Family and Friends, and welcome to the brand new year!

   We'd like to start this letter with some very good news.  We begin 2008 by welcoming a new employee to our firm.  Karen Bent has joined St. Nicholas Private Asset Management as a Senior Vice President and will be serving clients from her Lake County office as a Trust Advisor, Relationship Manager, and Business Development Specialist.  Karen is a Certified Trust and Financial Advisor (CTFA) and comes to us with almost 30 years of experience in the Trust and Investment Management industry.  This is somewhat of a reunion for Karen - both she and Tim worked together at SunTrust in Leesburg during the late 80s and early 90s, and she even brings clients with her that they both shared way back when.  Karen's hiring not only brings additional security and longevity to benefit our existing clients, but it also brings exciting new growth opportunities and extends our footprint into additional markets.  Needless to say, we are incredibly excited to have such a respected and qualified professional like Karen help make St. Nicholas even more successful for years to come.
   Coincident with Karen's addition, we are also pleased to announce that our custodial agent, Charles Schwab, began offering corporate trustee services in the fourth quarter of 2007.  We selected Schwab as our primary custodian for many reasons, but one of them was their reputation among investment advisors for their work in helping advisors generate new business.  Schwab's foray into the corporate trustee world is just another way that they help facilitate growth for investment firms like us.  Now, we have the ability to offer prospective clients a low-cost corporate trustee that allows the client the flexibility to choose us as their investment advisor.  This opens an entirely new niche of clients for us, so if you're interested in hearing about our new level of trust options, please give Karen or Allen a call.

 The "R"- word...
   We'll follow shortly with a review of 2007 results, but feel it's important to start this letter with a discussion of what's impacting today's market.  Our third quarter letter was certainly easier to write and probably easier to read.  At the time, we were looking at double digit returns in the equity markets, and even though we forecasted decelerating growth, we still hoped that a resilient consumer and cooperative Fed would guide us to a comfortable year-end.  Well, as it turns out, the third quarter appears in hindsight to be the end of the rainbow.  While St. Nicholas clients still enjoyed annual returns that were well-above the S&P 500, the overall equity markets ended the year with returns that barely beat money market returns. Since year-end, the equity markets have fallen flat on their figurative faces.  Perhaps we should have taken the first trading day in 2008 as an ominous sign.  January 2nd opened with the largest first-day decline that we have seen in 25 years, and the return landscape has only worsened since.  At this writing, the DJIA has already seen half of this year's trading days down by more than 100 points, and intra day swings of hundreds of points has occurred every day thus far.
   Why all of the negative volatility?  Very simply, blame it on the "R"-word.  Yes, the prospect of recession is more frequently rearing its ugly head.  While St. Nicholas has been cautioning about decelerating growth for some time, we have yet to predict a full-blown recession.  This stance has now put us in the minority.  A majority of the major investment banking houses including Goldman Sachs, Merrill Lynch, and Morgan Stanley, are now saying that the economy has already entered a recession.  We are starting to see a consensus of opinion become steered in that same direction, and the markets are certainly continuing to discount at least some level of slowdown in economic activity.   We won't know for certain whether we are in a recession until well after-the-fact, however, it has long been evident to us that the economy has been showing obvious signs of slowing.  Fortunately, all of the proponents of recession thus far have several things in common - that the slowdown will be minimal, that it will be confined to the first half of the year, and that the immediate and direct accommodation by the Fed will result in a second half rebound that may well keep GDP positive for the year.  None of these scenarios, however, will alleviate recession concerns as we enter 2008, so expect continued volatility with some pretty big intraday and full-day swings.  This will probably be the year where we re-experience a 500-point or even a 1,000-point down day.  Still, we are not fully convinced that a long-lasting recession is in the offing and feel that this short-term volatility will have to be tolerated in order to benefit long-term from the positions that we currently hold.  Also, there is always the possibility that everyone is wrong, and that no recession occurs at all - this is consistent with the Fed's outlook that they will act to avert a recession and that we are currently in a still moderate growth environment.  In any case, we re-emphasize that equity investors absolutely must consider their investments to be long-term, and that the most appropriate approach is to select the best companies and continue to hold them through thick and through thin...and...be prepared...it looks like we're heading into some "thin"...
 
4th Quarter Review
   We've already mentioned that the roller coaster ride of the 2007 stock markets ended closer to the lows than the highs for the year.  As it turned out, 2007 was simply not a very good year for the markets.  However, we had continually professed that it would be a stock-picker's market, and our prowess in that arena benefited our clients greatly.  For the year, the total return on the S&P 500 was only 5.5%.  However, all of the St. Nicholas individually-managed equity portfolios outperformed that index, with our average annual returns ranging from 8% to 16% (returns will vary due to account-specific factors, but our general discipline is applied to all individually-managed equity accounts).   This attractive relative performance can't be promised for every year going forward, but we are certainly proud of our achievements and feel that they go a long way in proving that our stock selection process possesses the foundations and characteristics of a successful strategy.
   Domestically, NASDAQ led US indexes for the year with a total return of 9.8%.  The DJIA was a close second, returning 8.9% for the year and the S & P 500 placed a distant third with a 2007 return of only 5.5%.  With the exception of Japan, overseas was the place to be.  The MSCI EAFE Int'l Index returned 11.6% last year, but emerging markets investors left everyone in the dust with a 2007 return of nearly 40%!  Fortunately for St. Nicholas clients, we had emerging markets exposure throughout the year, and we were able to avoid catastrophes in other international markets like the Nikkei's return of -11%.  Fed rate cuts starting in September rallied bonds throughout the fourth quarter and resulted in bond market returns of about 7% for the year.
   The Federal Reserve Bank had last raised interest rates in June 2006, and chose to leave them unchanged until late 2007 when credit concerns threatened adverse economic effects as financial market disruptions endangered growth.  Three rate cuts since September have now left the Fed Funds Rate at 4.25%, and further rate cuts in the first half of 2008 are a given.  Lower rates translate into higher inflation expectations and the new rate cuts did nothing to help soaring commodities prices.  This, combined with the prospects for economic woes, has pushed gold near the $900/ounce mark.  Oil also continued its surge, pushing above $90/bbl in the quarter, and has since hit the century mark in 2008.  While geopolitical and supply issues will continue to impact oil prices, our inclination would be to not expect any material price declines in oil, with the likelihood that we'll be well-above $100 at different points in 2008.  We have even seen some worst-case naysayers that have oil above $150/bbl sometime later this year.  Oil at those levels, or any level that pushes pump prices above $4 per gallon, will most assuredly have economic impacts that will get us the recession that everyone is calling for.
       
An Accommodative Fed
     We had already admitted in our previous letter that we missed our 2007 Fed call - we predicted no change for the year and the Fed cut rates three times near the end of 2007.  We are also a bit surprised that the Fed has publicly conceded that they are as much concerned about the financial markets as they are about the economy.  However, we are now of the thinking that it isn't so much that the level of the stock markets is the concern as much as it is that the Fed is clearly seeing a bigger picture concern.  The Fed is definitely not a political animal, and has an impressive history of acting independent of the wishes of political leaders and/or potential Presidential candidates.  We don't expect that independence to change in this election year, regardless of the new Fed leadership under Bernanke.
   What we are concerned with is that the Fed is obviously frightened by the looming prospect that declining equity and real estate markets will have a longer-term detrimental impact on the economy.  We get a sense, however, that this fear is not coming from the relationship of financial markets to US economic growth.  Our sense is that the fear is a much bigger animal...that the Fed sees things that we do not.  Perhaps this fear is similar to the financial crises that we experienced in 1998 with a hedge fund group called Long Term Capital Management (LTCM).  While the markets were fairly healthy in 1998, a confluence of events including the Russian debt/monetary collapse caused a liquidity crunch that exacerbated the already weakening condition of LTCM.  The unregulated hedge fund, managed by the smartest financial minds in the world (including 2 Nobel Prize winners), was now imploding.  The logical answer would be to let it implode and pass the losses on to its investors.  The problem was that the fund was so overleveraged that it would drag some of the largest financial institutions in the world down with it.  LTCM had leveraged $4 billion in real assets into $125 billion dollars, a leverage factor of over 30 times.  In addition, LTCM had leveraged off-balance sheet items whose notional principal approached $1 trillion!  Clearly, the economy was healthy enough for the Fed to remain on course, and the Fed never actually acted, but they did send a very clear message that they were willing to stand behind the banks by pumping immediate and massive amounts of liquidity into the system to avert what would likely have been the worst mass bank failure ever.
   The question now is whether there is another LTCM-type of web out there.  Real estate booms come and go; the sub-prime crisis should be fairly limiting if only due to the fact that sub-prime loans are such a small percentage of the total loan volume that exists today; and, increased loan losses due to higher foreclosures as ARMs adjust and payments get too high should be expected.  All of these are fairly common occurrences following real estate booms, and all of these have historically been self-correcting events.  Why then, is the Fed so quick to jump in to support the financial markets?  We have no evidence to believe that another LTCM-like debacle will result with a stock market decline, but we still think that the Fed has its eyes on some fairly large players that may be much more leveraged to the credit crises and equity markets.  For whatever reason, we know that the Fed will be reducing rates again.  The end result may likely be that we keep the US economy out of recession by artificially supporting the financial markets with cheaper money.  Expect the Fed to be over-accommodating during the first half of the year and the Fed Funds Rate to approach 3%, but don't be surprised if this only extends our growth phase today at the expense of a possibly worse recession scenario down the road.

The Equity Markets...Close your eyes or hold your nose (or both)...
     It's possible that we shouldn't complain to loudly about the dismal equity market returns last year.  In spite of excellent performance for St. Nicholas clients, the reality was that 2007 did not offer much from the get go.  We entered the year with obviously decelerating growth and the possibility of further slowdowns was certainly aided by higher oil and commodity prices, the continuation of the real estate swoon, and the sub-prime-induced credit crunch.  Still, through all this the consumer remained resilient enough to keep the economy growing at a fairly steady pace.  So, now we ask, will the consumer be enough to keep growth above recessionary levels in 2008?  We have a tendency to believe that the consumer, among other factors including the Fed, will keep GDP growth positive, although the deceleration in growth will be come much more evident on a stock-by-stock basis. 
   We have already noted our prediction for some pretty big down days this year, and we aren't quite ready to declare a positive return year for stocks just yet.  Stock market investors will need to see some evidence of improving conditions before the overall markets can resume any long-term increase.  We think the equity market can continue to decouple itself from an ongoing decline in real estate prices, but investors will have to see a resilient consumer, a supposed end to credit and loan losses, and maybe even some stabilization in oil prices before stock markets begin to re-attract long-term money.  During this time, expect to see the typical cyclical sectors (retail, financial, industrial, materials, and technology) under-perform and the traditional safe-haven sectors (health care, staples, energy, and utilities) outperform.
   Many of you may be tempted to ask questions like "Why don't we own more utilities and health care and sell some of the cyclical holdings" or "Why do we own technology stocks if they decline during recessions"?  These are very important questions and our answers are primarily threefold.  First, remember that the stock market has predicted 18 of the last 10 recessions.  This is our tongue-in-cheek way of saying that recession predictions may simply be wrong, and being out of our favorite long-term stocks simply because a recession is being predicted could prove to be costly.  Second, assuming a recession does come, its duration will determine whether any short-term re-allocations will pay-off.  If a recession lasts 3-4 years, sector shifts may be very beneficial.  However, keep in mind that over the past 50 years the average recession has lasted only 10 months, and we'd be more inclined to sit tight through a downswing that may be less than 12 to 15 months.  Our rationale here is that it is just too difficult to pick the correct exit and re-entry points.  The 10, 20, or 30 percent that we might save by getting out early will be just as easily lost by not being back in at the right time when the market begins to price in a recovery.  Holding the best names through the downturn and subsequent recovery pretty much leaves us in the same place as we started and we don't risk being out of the market in the crucial 10 or 15 days that can generate the bulk of any given year's return.  Finally, there are some tax implications of over-repositioning.  Given that we have had a decent returning equity market over the past 3 years, we have many positions that have unrealized capital gains.  If we still want to hold those particular names long-term, it doesn't make sense to try and time a temporary departure from those stocks at the expense of a 15% capital gains tax bite.
  The end result is that we will be looking for further confirmation of a recession before conceding that we are in one.  Also, even if a recession does occur, we feel that current conditions set the stage for a fairly limited economic decline and an even faster recovery.  Despite the credit crisis, we still can't deny that there are many positive factors that support at least some minimal level of economic growth.  These factors include low rates that are going lower, a fairly resilient consumer, a strong global economy, and inflation numbers that are still quite low.  Combine these positives with an equity market whose valuations are getting cheaper by the day, and stocks still don't look too bad.  Recession or no, a 10%-plus correction is not out of the cards, but we've seen that level of price correction in virtually each of the past 5 years, so that level of volatility should be expected.  Still, we also don't look at any recession as inherently bad - it's a self-correcting event that ultimately benefits longer-term growth.  And, recessions make things cheap - Warren Buffet will gladly brag that some of the best investments he ever made were during the recession of the mid-70s.  We're not predicting the near-depression conditions that existed during that era (we're not even ready to get on the recession bandwagon just yet), but we're certainly not afraid to own stocks just because we're due for some eventual short-term downswings.

The Bond Markets - Finally their day has come.
   We were only off a little bit on our bond predictions last year.  We had forecasted that bonds would basically make their coupons, meaning returns would fall in the 4%-6% range.  That level would have been overly optimistic had the Fed not begun cutting rates in September, but with bond returns in the 7% range for the year, bond investors finally had something to smile about.  Bond returns not only outpaced most domestic equity measures, but the long bond return of over 9% beat equity market returns for the first time in 5 years.
   Given the weakening economy, and the recessionary predictions, we would be inclined to expect more of the same for bonds in 2008.  We have already stated that the Fed is in a rate-cutting mood, and how much they cut will determine how much bond investors make this year.  It is safe to assume that 2008 will be a positive year for bonds.  While that may not be saying much, remember that we were not able to make the same prediction for stocks.  The question for bonds will be just how positive.  We are willing to set a range for bond returns of the coupon plus 3% to 4%.  Before concluding that this may sound like a pretty attractive return, remember that rates have already come down considerably with 2-year Treasuries only yielding 2.5% and the 10-year at only 3.7%.  Adding 3 or 4 percent to those levels will get you a similar return year as 2007.  Overall, bond investors should be comfortable throughout most of 2008 - bond prices will level off when the Fed stops reducing rates, but the prospects for any Fed rate increase during 2008 are very, very, small.
   In conclusion, we're likely at a turning point for the economy.  The Fed will be accommodative, but avoiding a recession will be on the shoulders of the US consumer.  Equity market volatility will be high this year, but really, when isn't it?  Long-term stock investors will do well to ignore the media sensation that will focus on the short-term - recessions and corrections are normal occurrences, and we have a strong underlying economy that has always found its way to recovery.  Remember, stocks are a long-term endeavor.  We may be lower three to four months from now, but we have no reason to believe that we won't be handsomely rewarded three to four years from now.  For now we're comfortable staying the course and exercising what will probably have to be a much higher level of patience. 

Wishing You a Prosperous, Rewarding, and Healthy 2008!